Nobody likes to lose money. And yet, trading requires a constant cutting of losses while letting winning trade run.
So how do you stop the pain of losing money?
Stop orders are a type of order that has been around for many years. They are used to "stop" you out of a trade. Like a trade that has taken a turn for the worst and is no longer a winning trade for you.
Stops are one of the easiest ways to minimize losses in your trading account.Unfortunately most retail traders do not use them. It is not clear why people don't use them. Maybe because they don't know how. Or because they fear getting stopped out of a trade that ultimately would have been good. Either way, it is important that you overcome the fear and learn to use a stop order.
So what are the different type of stop orders that can be set?
There are 3 basic orders and 1 more advanced order that I'm going to discuss here.
The basic stop order is a regular ol' plain jane "stop". In it's most simple form, it is a trigger order that says "if my stock price hits this price point, then sell my stock".
Contrary to popular belief, a stop order is only sent to the floor if the price objective is met. Many people believe the market makers are sitting at their desks looking for stop orders to go fill. This is simply not true. The orders reside on your broker's system until the criteria is met. At that point, the order is sent to the floor and executed.
A basic stop order sends a "market" order to the floor, which means the order is to be filled as quickly as possible at whatever price. If you are in a hurry to liquidate a position, this is the order you should use, but if you want to guarantee the price you will sell at, the market order is not the one you want to use.
A stop limit order is similar to a basic stop order. It is also a trigger that, if the criteria is met, will send an order to the floor to sell your position. However, with the stop limit, the order that is sent to the floor is a "limit order", not a market order.
If you are not familiar with limit orders, limit orders set a limit to how much you are willing to accept for your trade. For example, if you place a LIMIT order to sell XYZ stock at $34.50, your broker is required by law to make sure that order is filled at $34.50 or better.
At face value, the stop limit is a better order to place because you can control the price at which your position gets liquidated. However, there are some built-in weaknesses to this type of order. Specifically, what if the price of the stock can't be sold at your limit price? You will be stuck holding the position!
Have you ever heard of someone complaining that "the stock gapped over my stop"? That person is talking about a stop-limit order. It is possible (and in fact happens often) for a stock to move beyond your limit price faster than the trade can be liquidated. In this case, you will continue to hold the position and it will appear your stop was a worthless transaction.
The stop-limit is not specifically good or bad, it is simply a variation of a stop order. It can be a beneficial order and can help lock in a higher price for your stock, but it can also leave you exposed if the trade moves very quickly against you.
The trailing stop is designed to "maximize profits" by trailing higher and higher with your trade. As the stock moves higher and higher the trailing stop will automatically adjust to "lock in" more of the profit.
When a trailing stop is hit, it triggers a market order which will sell the position as the fastest available price at that time. Some brokers do allow for a trailing stop limit order, but it is difficult to anticipate where the limit price should be with the trailing stop. So most people settle for using a market order.
Trailing stops can be beneficial in certain circumstances, but in my opinion, they are not effective at actually locking in additional profit. In order for the trail to be triggered, by nature you will always be selling on a down tick. I have found in most cases, it is best to trade to a target price and simply take your profits.
Finally, let's talk about the contingency trigger. Most brokers today allow for a "contingency order". Some call them "criteria orders" or "conditional orders". They all mean the same thing. It is simply an order that must meet a certain criteria before being sent to the floor to be traded.
There are many uses for contingency orders. But one often overlooked use is as a stop.
Think about it this way, a basic stop order is simply a contingency order that says "if my stock hits this price, then place a market order to sell".
That same script could be written with a contingency order. However, by choosing "contingency order" instead of "stop order" it opens up a lot of additional flexibility that a straight stop order can not accomplish.
For example: Let's assume you are trading an option on XYZ stock. You want to set a stop for the option based on the price of the stock. This order is not available in most brokers, however, it is available through a contingency order.
In this case, you would simply setup a contingency order that says "if XYZ stock hits 'x' price, then sell to close my call options at a market order".
Let's be more specific. Assume you are trading AAPL and have purchased some call options. You want to set an order to sell those options if AAPL drops below a certain price. In the order form below you can see the two parts to the order. Part 1 is the criteria. "If AAPL has a last price that is less than $107.00". Part 2 is the actual order. "Then sell to close my 10 call options at a market price".
This script above is essntially the same script of a basic stop order, except this script allows you to place that order based on the stock price, not the option price.
Conditional orders are an excellent tool for any trader, but particularly for option traders who want to set a stop based on the stock price rather than the option price.
Here we have looked at the most basic type of stop orders. Regardless of what kind of trader you are, Short term, intermediate, long term or day trader, setting a stop should be a crucial part of your trading plan and your capital preservation plan.
Like the old saying goes, "failure to plan is planning to fail", we could adapt that and say "failure to trade with a stop is planning to stop trading"